11
HFT 4464HFT 4464
Chapter 2Chapter 2
Financial Markets &Financial Markets &
Financial InstrumentsFinancial Instruments
2-2
Chapter 2 Introduction
This chapter will provide an introduction to financial markets and common financial instruments.
Financial markets are where suppliers of capital (firms) interact with buyers (investors).
Often this is done through intermediaries such as brokers.
2-3
Why Do People Invest?
Investing is not just something other people do.
College education is an investment.
Investing is more than just hoping to “make some money.”
It involves deferring present consumption in the hopes of higher future consumption.
2-4
Equity Capital Types of equity capital
Preferred stock“Dividend” is fixed as a % of price
Common stockNo guarantee of dividendOne share, one voteShareholders vote on key issues, such as
board of directors, choice of auditing firms, etc.
2-5
Why Purchase Common Stock?
A purchaser is looking for at least one of two possibilities:
1. Stream of dividend payments (current income)
2. Increase in stock price (capital gain)
3. Sales price dependent on future cash flows
1. Size, timing, risk
Holding period return:
{ ( (sales price – purchase price) + dividends ) / Purchase Price } x 100
2-6
Holding Period Return Example
You purchased a share of McDonald’s stock one year ago for $18.00.
You earn $2.00 in dividends during the year. Today you sell the stock for $18.50. What is your holding period return?
(($18.50 – $18.00) + $2) / $18.00 = 0.1389
0.1389 x 100 = 13.89% (before taxes)
2-7
Bonds
Held by lenders Receive repayment over time
Semi-annual interest paymentsAt maturity, amount is repaid (principal)
This is a series of cash flows that has value Priced on an index relative to 100 If a $1,000 bond sells for “102,” it sells for $1,020
Based on present value of future cash flows
2-8
How to Interpret Bond Information
Bond Curr. Yld Vol Close Chg
Hilton 73/4 14 7.67% 40 101 +1/2
The Hilton bond pays 7.75% interest and matures in 2014.
The annual interest divided by the current price is 7.67 percent. (Note: this is not the return you will receive if you hold the bond till maturity.)
40,000 bonds were traded that day.
The bond closed at $1,010 which is $.50 higher than the previous day.
2-9
Calculating Bond Yield
Bond Yield: (Face Value of Bond x Interest Rate) /
Current Price of Bond Current Interest of Bond from
Current Yield: (Current Price of Bond x Yield)/Face Value of
Bond If bond sells at a premium, yield will be lower If bond sells at a discount, yield will be higher
2-10
Capital Markets
Represents a diverse group of investmentsStock marketBond marketMortgage marketFutures market
2-11
Stock Market New York Stock Exchange (NYSE)
Founded in 1792
Physical location on Wall Street in New York
Approximately 2,800 companies offering securities here
Membership offered in the form of seats
2-12
Stock Market Nasdaq
National Association of Securities Dealers and Automated Quotations
Not a physical location like the NYSE (“over the counter”)
Represents a network of securities dealers
Fastest growing securities market
Makes use of “market makers”—help ensure liquidity of trading
2-13
Bond Market
Corporate bonds can be traded through the NYSE
Most bonds are traded over the counter
Bond ratings The lower the letter, the greater the quality Quality refers to the risk of default
Companies rating bonds Standard and Poor’s Moody’s
2-14
Important Features of Bonds How are bond prices and interest rates
related?As interest rates rise, bond prices fall.
Some bonds are callable.Company can repurchase bonds at a
certain price during a certain time.
2-15
Mortgage Market
Pooling of home mortgages by government agencies
FNMA and GNMA are two examples.
Mortgages are packaged and resold as securities to investors.
Investors are often large institutional investors like pension funds.
What did we see happen in 2008?
2-16
Money Market Market for short-term debt instruments
Certificates of Deposit
Commercial paperInvestors loan to large companies for a very short period of time
(9 months or less).
Treasury Bills / BondsLoans to the U.S. TreasuryZero-Coupon bondsIssued at a discount—no interest paymentsRisk Free Rate
2-17
Raising Capital
Primary marketInitial Public Offering (IPO)
Common stock is sold to underwriter (investment banker)
Investment banker sells to clients
Secondary marketInvestor to investor, where most trading
occurs
2-18
Features of Stock Trading
Bid vs. ask Bid is the price you will pay to own a share Ask is the price you would receive to sell
your share Difference goes to broker
Average NYSE trade takes 22 seconds
Significant reliance upon computers
2-19
Hedging Risk
We can add value by decreasing the risk (variability) of cash flows.
The concept of insurance as hedging:You buy insurance and if nothing
happens to your house, you still have the house.
If your house is damaged, insurance pays for it and the house is rebuilt.
2-20
Forward and Futures Contracts Spot price—price paid for a commodity today
Change in commodity prices present, risk to buyer and seller
Example: Orange juice grower (seller) and restaurant owner (buyer)
Prices help growers determine what and how much to produce and restaurants need to establish menu price
2-21
Forward Contracts
An agreement to sell an asset at a fixed price for delivery in the future.
Cash payment is not required until delivery.
However, each party must trust the other to perform.
The unique nature of each contract makes them difficult to sell to third parties.
2-22
Futures Contracts
Similar to forward contracts, except: Terms of contract are standardized, such as amounts
and delivery dates. Clearinghouse acts as go-between to help ensure
performance. Contracts are traded on the Chicago Board of Trade
or Chicago Mercantile Exchange.
Most contracts are never delivered.
Parties take opposite positions to offset original position.
2-23
Foreign Exchange
As international trade barriers are removed, more business is conducted away from home country.
Nearly 65% of McDonald’s 2002 revenues originated from outside the U.S.
U.S. companies must report financial operations in U.S. currency.
2-24
Foreign Exchange Example
You operate a hotel in France and accept the Euro.
When the Euro strengthens, this means it takes fewer Euros to buy $1 worth of goods.
As the Euro strengthens, your profits increase upon conversion.
100,000Euros x $1/1Euro = $100,000 usd 100,000Euros x $2/1Euro = $200,000 usd
2-25
Can we hedge this risk?
Similar to commodities, we want to lock in a “price” for our Euros—an exchange rate at a future date.
We can buy a forward or futures contract to accomplish this.
Who would be on the other side of this transaction?
A French company (or other company accepting the Euro) operating in the U.S.
2-26
Lenders to the Hospitality Industry
Commercial banksTraditionally largest lenderBank makes a “spread”—difference between
interest rate on loans and rate on depositsInterest = principal x rate x timeTypes of loans
Fully amortized (principal and interest)Interest only
2-27
Lenders to the Hospitality Industry Real Estate Investment Trusts (REITS)
There are equity and mortgage REITS Special tax treatment if they pass through at
least 95 percent of earnings to investors
Insurance companies and pension funds Receive large monthly cash flows from
premiums and contributions Try to match assets (loans) to liabilities (policies
and pension needs)
2-28
Measures of Stock Market Performance
Dow Jones Industrial AverageIndex of 30 large companiesWeighted by stock price
Standard and Poor’s 500 (S&P 500)500 companiesFairly common measure of overall stock
market performanceMovement is similar to the Dow
2-29
Some Stock Market Statistics Mean—weighted average
Mean Dow annual return (1950–2001) = 9.01% Mean S&P 500 annual return = 9.63%
Returns in a single year have varied from –30% to +44%
This uncertainty around the mean is called variance
Another measure is standard deviation, the square root of the variance
2-30
Some Stock Market Statistics
Can we measure the relationship between two individual stocks, two stock indices, or an individual stock and a stock index?
Correlation coefficient = Range is from –1.0 to +1.0 +1.0 is perfect positive correlation -1.0 is perfect negative correlation The Dow and the S&P 500 are highly
positively correlated
2-31
Review Key Calculations
Holding Period Return Bond Quotation Bond Yield
32
Homework Assignment
Problems 1,2,3,6,7
Top Related